A 60:40 allocation to passive long-only equities and bonds has been a great proposition for the last 35 years …We are profoundly worried that this could be a risky allocation over the next 10.” – Sanford C. Bernstein & Company Analysts (January 2017)
Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria” – Sir John Templeton
Life and investing are long ballgames.” – Julian Robertson
It’s no secret that I’m bearish on real return prospects for U.S. stocks and bonds. After all, I have been putting together a table like this one, which has proved inaccurate thus far, since 2015.
(Source: Author, GMO)
Looking at the table above, which shows prospective real returns on an annual basis for the next seven years, GMO has become more progressively bearish on future bond real returns, and I have too, articulating in a recent article that the bubble in the bond market is nearing the end of its euphoria.
Building on this narrative, as bad as the real return prospects look for U.S. equities, these return prospects have actually improved from a year ago, as the stock market continues to churn, passing time, while the bond market bubble has continued to expand.
The end result is that both the U.S. stock market and U.S. bond market remain historically overvalued, with the equity market keeping rare company with 1929 and 1999 historically overvalued equity valuation templates.
Market participants have noticed these eerie parallels and intuitively understand that higher starting valuations are synonymous with lower future returns.
This fear has collided with the extraordinary market structure imbalances, with seemingly everyone pursuing defensive strategies, defensive growth strategies – think disruptive growth leaders like Amazon (AMZN) or Netflix (NFLX) which excel in a price-cutting world – or defensive dividend growth strategies, creating a market where almost everyone is collectively worried and fearful, yet simultaneously piled into historically crowded investments, and investment strategies.
These historically-crowded trades are ripe for an unwind, something we have seen occurring on a regular basis going all the way back to the volatility unwind early in 2018, and really back to 2016, where historically crowded trades reversed as I articulated, and accurately predicted in one of my favorite titled public SA articles.
This time, the trades are even more crowded and the unwind could be a melt-up higher in the broader stock market, think the S&P 500 Index (SP500), led by the historically out-of-favor economically sensitive assets, which have been left for dead, as almost all investors and traders expect a near-term recession, which as bearish I am on long-term returns for the broader U.S. stock and bond market I do not think is going to happen.
Fear Is Palatable
The American Association of Individual Investors runs a weekly sentiment poll where participants express their view on which direction the U.S. stock market will be headed over the next six months, and the results for the week ending Oct. 9, 2019, illustrate the underlying prevalent fear in the financial markets right now.
The current bullish-bearish spread, which is a -23.7 reading (this is calculated by subtracting the bearish sentiment reading from the bullish sentiment reading), is actually very close to the low reading registered at the stock market’s depth in December of 2018, where the Bull-Bear Spread printed a -28.0% reading for the week ending Dec. 13, 2018.
The Divergence In Sentiment With The S&P 500 Index Is Striking
When the AAII Bull-Bear Spread posted a -28.0% reading for the week ending Dec. 13, 2018, the stock market was in the middle of a plunge that would culminate in a Christmas Eve 2018 closing low of 2351.10, as shown in the chart below.
(Source: Author, StockCharts.com)
This morning, Thursday, Oct., 10, 2019, as I write this piece, the S&P 500 Index is currently at 2937.35, up 0.6% on the day, and 24.9% higher than its closing low on Dec. 24, 2018.
Summarizing, sentiment is currently almost as negative as it was ahead of the December 2018 lows, yet the S&P 500 Index is roughly 25% higher than its December 2018 closing lows.
The Bond Market Is Showing A Different Divergence
Comparing and contrasting the sentiment and price action in the S&P 500 Index, where there is positive divergence between sentiment and price, to what’s occurring in the bond market, is striking too, with the iShares 20+ Year Treasury ETF (TLT), currently trading at 142.59, down 1.2% on the day as I write this article, up 19.5% from its December 2018 adjusted closing high of 119.32 (adjusted for dividends), which occurred on Dec. 31, 2018.
The S&P 500 Index has risen roughly 25% from its December 2018 lows, even though sentiment is at a similarly negative level today, as the broader U.S. stock market has been led by the performance of defensive equities, and interest rate sensitive equities, spurred on by the performance of the bond market, where long-term bonds have risen roughly 20%, as investors of all stripes flock to safety.
Closing Thoughts – The Safety Trade Will Need To Unwind Before The Stock Market Tops
In 25 years of personal investing experience, including over two decades of professional investing experience, combined with the perspective of a market historian, who has combed through more analysis, data, and testimonials than anyone else I know (one of the reasons I thoroughly enjoying participating in this community), I cannot ever recall a significant downturn happening in the stock market, or in the economy, when a majority of market participants were looking for one.
Throughout my study of market history, and through my actual experience, the financial markets have a habit of fooling as many investors as possible, and the curve ball this time, could be an inflationary melt-up, led by economically sensitive equities, and an unwind of the yield propelled safety trade, as sentiment shifts from overly defensive to more optimistic, all happening ahead of the long awaited downturn, which everybody is positioned for now, yet few will be positioned for when a significant downturn actually happens.
If this scenario unfolds, the current market leaders, think the investments that have excelled the past several years and the past decade, including large-cap growth stocks, specifically the vaunted FAANGs, including Facebook (FB), Amazon, Apple (AAPL), Netflix, Alphabet (GOOGL), (GOOG), which are really the longest duration assets in a world starved for growth, dividend growth stocks, including the hyper-valued defensive stalwarts like Procter & Gamble (PG), McDonald’s (MCD), Coca-Cola (KO), interest rate sensitive investments, including REITs (VNQ), (IYR), and utilities (XLU), and the heavily embraced bond market, as described earlier, are all poised to underperform dramatically, as a historic capital rotation, which will make 2016’s reversal look tame in comparison, is poised to surprise most investors.
In closing, embracing shunned economically-sensitive assets, when almost all market participants are buying quality, front running the passive and ETF flows, and preparing for a downturn, is perhaps the perfect storm of a contrarian opportunity.
The economically sensitive equities that have the potential to rise from the ashes like a Phoenix, include energy equities, which are historically out of favor, and which I have written about extensively over the past several months, with a public article on Exxon Mobil (XOM), an article providing a historical comparison of the natural gas industry in the United States, and another public article on Antero Resources (AR), with all of these articles providing perspective on the historic opportunity from my vantage point.
There is historic opportunity in the investment markets today. I have spent thousands of hours analyzing the markets, looking for the best opportunities, looking to replicate what I have been able to accomplish in the past. From my perspective, the opportunities in targeted out-of-favor equities today are every bit as big as the best opportunities in early 2016, and late 2008/early 2009. For further perspective on these opportunities, consider a membership to The Contrarian, sign up here to join.
Disclosure: I am/we are long XOM, AR, AND SHORT TLT PUTS, AMZN PUTS, SHORT PG, AND SHORT SPY IN A LONG/SHORT PORTFOLIO WHERE I EXPECT VALUE STOCKS TO OUTPERFORM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Every investor’s situation is different. Positions can change at any time without warning. Please do your own due diligence and consult with your financial advisor, if you have one, before making any investment decisions. The author is not acting in an investment adviser capacity. The author’s opinions expressed herein address only select aspects of potential investment in securities of the companies mentioned and cannot be a substitute for comprehensive investment analysis. The author recommends that potential and existing investors conduct thorough investment research of their own, including detailed review of the companies’ SEC filings. Any opinions or estimates constitute the author’s best judgment as of the date of publication, and are subject to change without notice.